This is a follow-up to the article Use of Interest Rates as an Economic Tool, and is a synopsis of an earlier discussion on the Economics Club Google Group.
Basically, to curb inflation, policy makers try to tighten the monetary policy so as to reduce purchasing capacity of the people. This results in reduced demand which therefore reduces price levels(downward shift in demand-price graph). For this they absorb a portion of the money supply, which they do by increasing interest rates. As explained in the previous article, increasing the interest rates would result in less spending and more saving, and therefore lesser money flowing in the economy.
However, the RBI is reluctant currently to increase interest rates. This is because of the large negative impact that has on businesses, and therefore on the GDP. Although one argument for interest rate hike is that real GDP is equal to nominal GDP(GDP measured in monetary terms in the year) divided by GDP deflator(equivalent to inflation), so that the nominal GDP rise is cancelled by the high inflation.
However if we look at the effect of rise in interest rate on the market, we see that interest rate hike reduces money flowing in the market, so that investment in projects will go down. Loans to entrepreneurs are also unfavorable which in the long term is negative for the economy For countries like India and China, which are focused on rapid economic expansion, an expansionary monetary policy with low interest rate is necessary, at the expense of high inflation. China for example has a high interest rate. This means that purchase levels have fallen, which means imports are costlier. But on the other hand a high interest regime actually encourages export, as exports bring money into the economy which can be invested with good returns. In the case of China, combining a high interest rate and rapidly increasing exports is possible because of the abundance of land and manpower. Also high interest rates attract foreign investment, which therefore creates a demand for the currency, so that the currency gains in value. But such a scenario is unstable because of the high foreign investment, which when withdrawn, could result in a considerable depreciation of currency. The risks can be seen in the example of the Latin American Debt Crises.
Basically, to curb inflation, policy makers try to tighten the monetary policy so as to reduce purchasing capacity of the people. This results in reduced demand which therefore reduces price levels(downward shift in demand-price graph). For this they absorb a portion of the money supply, which they do by increasing interest rates. As explained in the previous article, increasing the interest rates would result in less spending and more saving, and therefore lesser money flowing in the economy.
However, the RBI is reluctant currently to increase interest rates. This is because of the large negative impact that has on businesses, and therefore on the GDP. Although one argument for interest rate hike is that real GDP is equal to nominal GDP(GDP measured in monetary terms in the year) divided by GDP deflator(equivalent to inflation), so that the nominal GDP rise is cancelled by the high inflation.
However if we look at the effect of rise in interest rate on the market, we see that interest rate hike reduces money flowing in the market, so that investment in projects will go down. Loans to entrepreneurs are also unfavorable which in the long term is negative for the economy For countries like India and China, which are focused on rapid economic expansion, an expansionary monetary policy with low interest rate is necessary, at the expense of high inflation. China for example has a high interest rate. This means that purchase levels have fallen, which means imports are costlier. But on the other hand a high interest regime actually encourages export, as exports bring money into the economy which can be invested with good returns. In the case of China, combining a high interest rate and rapidly increasing exports is possible because of the abundance of land and manpower. Also high interest rates attract foreign investment, which therefore creates a demand for the currency, so that the currency gains in value. But such a scenario is unstable because of the high foreign investment, which when withdrawn, could result in a considerable depreciation of currency. The risks can be seen in the example of the Latin American Debt Crises.
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